Blame the Fed — Not Investors — For Asset Bubbles

In his speech on April 7 2010 at the Economic Club of New York the President of the New York Fed, William Dudley argued that asset bubbles pose a serious threat to real economic activity.

The New York Fed chief is of the view that the US central bank should develop effective tools to counter this menace.

According to Dudley, it should be the role of the Fed to stop the expansion of the bubble while it is still in the making.

By an asset bubble, I mean price increases (or declines) that become unmoored from fundamental valuations. 1

Dudley is of the view that the way people trade also generates bubbles. On this, he suggests that,

Bubbles may simply emerge from the way market participant’s process information and trade. In many carefully controlled experiments in which the intrinsic value of the asset could be determined with certainty, participants still bid prices up far above fundamental valuations, with the bubbles being followed by sharp declines in prices.

Furthermore, Dudley is of the view that,

A bubble is difficult to discern and, second, each bubble has unique characteristics. This implies that a rules-based approach to bubbles is likely to be ineffective and that tackling bubbles to diminish their potential to destabilize the financial system requires judgment.

In conclusion, the New York Fed President has suggested,

Let me underscore the challenge that central bankers face in combating asset price bubbles. Doing so effectively requires us to be successful in both identifying the incipient bubble and in developing and implementing a response that will limit bubble growth and avert a destructive asset price crash. This is not easy because asset bubbles are hard to recognize in real time and each asset bubble is different. However, these challenges cannot be an excuse for inaction.

The Fed and Bubbles – Is There a Connection?

From this way of thinking, it would appear that the Fed has nothing to do with bubbles and if anything, the US central bank is here to confront and eliminate the menace that poses a threat to the wellbeing of the US economy. However, does it make sense that bubbles have nothing to do with the Fed?

Now, according to popular thinking, an asset bubble is about a large, above historical average, increase in asset prices.

A price of a thing is the amount of dollars paid for it. This means that a bubble is about large, above the historical average, payment of dollars for various assets. As a rule for this to occur there must be an increase in the pool of dollars, or the pool of money. Therefore, if one were to accept the popular definition of what a bubble is one must also accept that without the expansion in the pool of money bubbles cannot emerge.

Once the pool of money starts expanding, various individuals that have access to the newly expanded money can divert various assets to themselves by bidding asset prices higher.

Furthermore, once the suppliers of goods observe that the prices of their goods are starting to go up they begin boosting their production.

As a rule, the increase in the production of goods becomes possible by securing bank loans. Note that some of these loans are made possible as a result of easy monetary policy of the central bank.

Note that the expansion in bank loans (lending out of “thin air”) enables the borrowers to secure various resources by bidding their prices higher. This of course leaves relatively fewer resources at the disposal of other individuals.

The Dynamics the Bursting Bubbles

As a rule, an increase in the growth momentum of money supply is followed by an increase in the growth momentum of asset prices. If for whatever reasons the central bank slows down the monetary pumping this will lead to a decline in the growth momentum of asset prices.

Consequently, some market players may start “locking” in profits by selling assets. As more and more investors try to protect their profits, this leads to a burst of the asset price bubble.

(Observe that a decline in the growth rate of money supply implies a decline in the growth rate of money that enters various markets, all other things being equal. This in turn means a decline in the growth momentum of asset prices).

As a rule, a decline in the growth momentum of money supply is usually set in motion by a tighter monetary stance of the Fed.

Contrary to Dudley, asset bubbles have nothing to do how people trade and their psychological disposition. It is purely a money printing phenomena.

So how can the central bank stop the emergence of asset bubbles? – By not engaging in the creation of money out of “thin air”.

Conclusion

At no stage in his speech did the New York Fed boss raise the possibility that the main source of asset bubbles could be the US central bank itself.

It is not enough to provide a description of the concerned phenomenon without outlining the essence of this phenomenon in order to make sense of it.

By ignoring the role played by money in the formation of bubbles, William Dudley finds it difficult to figure out what are the necessary means required for the preventing the occurrence of bubbles.

If Dudley had made a more focused effort to understand, the essential driving variable of bubbles he would have reached the conclusion that without central bank’s loose policies bubbles could not have emerged.

1. William C. Dudley – Asset Bubbles and the Implications for Central Bank Policy. Remarks at the Economic Club of New York. April 7 2010.